Dreman argues in favor of using a low P/E stock strategy since it has a long track record of success having worked over the past 40 years. He explains some ways to be more selective over which low P/E stocks to buy based on indicators that he has tested. Since it might be difficult for the investor to buy all of the low P/E stocks, Dreman provides some guidelines to narrow the number of choices. First, within the low P/E stock universe, look to diversify equally into 15 to 20 stocks and across 10 to 12 industries. This diversification strategy should reduce the risk to investors and allow a good chance of achieving results similar to investing in the entire low P/E quintile. Dreman actually prefers to consider the bottom 40% of low P/E stocks to offer sufficient diversification choices.
Secondly, look to buy mid to large cap sized low P/E companies. One problem with small cap stocks is that they are not under the same amount of public scrutiny as the larger cap stocks. More accounting shenanigans can occur unnoticed with smaller sized companies. Additionally, more of the smaller sized companies go bankrupt compared to the larger sized companies.
In addition to these general rules, Dreman provides some indicators which he feels are helpful to the selection criteria of low P/E stocks (please refer to the book for all given indicators). One indicator is that the company should have a strong financial position. A second indicator is that the stock should have a higher rate of earnings growth than the S&P 500. Another indicator is if the stock has a high dividend yield that is sustainable and can be increased.
Although the question of when to sell a low P/E stock doesn't have one correct answer, Dreman advises that a good rule of thumb is to sell when the P/E ratio approaches that of the overall market. If a low P/E stock does not look to be working out his advice is that it's best to hold on for a period of 2 years.
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